BUSINESS VALUATION UNDER DISCOUNTED CASH FLOW (DCF) METHOD
Given below is a live example of Pre-Money Valuation conducted for a US-based startup, using Discounted Cash Flow Method (DCF), for raising seed capital. The figures given are just for example.
Discounted Cash Flow (DCF) analysis is a method of valuing a pre-revenue startup using the concepts of the time value of money. All future cash flows are estimated and discounted by using the cost of capital to give their present values (PVs). The income approach recognizes that the value of an investment is premised on the receipt of future economic benefits. These benefits can include earnings, cost savings, tax deductions and the proceeds from disposition. Discounted Cash Flow Method is a form of the income approach that is commonly used to value businesses or equity interests.
RATIONALE FOR THE SELECTION OF DCF METHOD
- Under a DCF approach, forecast cash flows are discounted back to the present date, generating a net present value for the cash flow stream of the business. A terminal value at the end of the explicit forecast period is then determined and that value is also discounted back to the valuation date to give an overall value for the business.
- A Discounted cash flow methodology typically requires the forecast period to be of such a length to enable the business to achieve a stabilized level of earnings or to be reflective of an entire operation cycle for more cyclical industries.
- The rate at which the future cash flows are discounted (“the discount rate”) should reflect not only the time value of money but also the risk associated with the business’s future operations. The discount rate most generally employed is Cost of Capital (“CoC”); here it is Cost of Equity (“COE”) only since there is no debt capital.
- In calculating the terminal value, regard must be had to the business’ potential for further growth beyond the explicit forecast period. The “constant growth model”, which applies an expected constant level of growth to the cash flow forecast in the last year of the forecast period and assumes such growth is achieved in perpetuity, is a common method.
- The rate at which future cash flows are discounted should reflect not only the time value of the cash flows but also the risk associated with the business’s future operations. This means that in order for a DCF to produce a sensible valuation figure, the importance of the quality of the underlying cash flow forecasts is fundamental.
COST OF CAPITAL UNDER CAPM METHOD
Cost of Capital is a discount rate used to determine the present value of the expected returns of a business. Generally speaking, the discount rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment. In DCF valuations, the discount rate, often an estimate of the cost of capital for the business is used to calculate the net present value of a series of projected cash flows. The discount rate can also be viewed as the required rate of return the investors expect to receive from the business enterprise, given the level of risk they undertake.
There are two separate discount rates required for Valuation purpose which is mentioned below:
Since, in the given case, there is no debt capital in the proposed financial model and the objective of this valuation is to raise equity capital from investors, the Cost of Capital (“CoC”) here includes only the Cost of Equity (“CoE”).
These methods are discussed in detail below.
CAPITAL ASSET PRICING MODEL (CAPM) FOR “CoC”
The capital asset pricing model (CAPM) provides one method of determining a discount rate in business valuation. The CAPM originated from the Nobel Prize-winning studies of Harry Markowitz, James Tobin, and William Sharpe. The method derives the discount rate by adding a risk premium to the risk-free rate. The risk premium is derived by multiplying the equity risk premium with “beta”, a measure of stock price volatility. Beta is compiled by various researchers for particular industries and companies and measures systematic risks of investment.
The Cost of Equity (CoE) is expressed formulaically below:
The CoC (CoE), Based on the above parameters, after applying the above formulae, is arrived at 40.34%
VALUATION UNDER DCF METHOD
In order to arrive at the Net Present Value of the business, the following steps must be solved.
- Calculation of Free Cash Flow to Firm (FCFF).
- Arrive at the Present Value of Explicit FCFF using the Cost of Capital (Cost of Equity “CoE”) calculated as above.
- Determine the Terminal Value using Growth Rate and CoE.
- Determine the Present Value of Terminal Value using CoE.
- Arrive at Total Present Value by adding the results of step II and step IV. Add the opening balance of cash& cash equivalents with the result of step V to arrive at the Pre-Money Value.
1. Free Cash Flow to Firm (FCFF)
FCFF is a measure of financial performance that expresses the net amount of cash that is generated for a firm after expenses, taxes and changes in working capital and investments are deducted. We have arrived at Explicit FCFF by the following method.
2. Present Value Of Explicit FCFF
Using the Cost of Capital of 40.34% as determined above the Present Value of Explicit FCFF has been given below.
Present Value of Explicit FCFF= FCFFn / (1+Ke)^n
Present Value of Explicit FEFF
3. Future Value Of Terminal Value
- At the end of the forecast period, it is assumed that the net profits and hence the corresponding cash flows generated by the Business will continue indefinitely.
- For the purpose of calculating Terminal Value, we have used the globally accepted method- Perpetuity Growth Method or Gorden Growth Perpetuity Method.
- The most common approach to calculating terminal value is to apply a constant growth model, utilizing the following formula:
– FV of terminal value = [FCFFn] x (1+g) / (Ke-g)
4. Present Value of Terminal Value
PV of terminal value = FV of terminal value / (1+Ke)^n
Present Value of Terminal Value
5. Valuation under DCF Method
The Value of the Business under the DCF Method using CoC of 40.34% (under the CAPM method) and a 6% growth rate has been given below.
Valuation under DCF Method = $ 5,645,823
Please comment your views and suggestions.
Thanks and regards
- SBA 504 Loans- everything you need to know
- Top 20 SBA 7(a) Lenders in the US
- SBA 7(a) Loans- a complete guide on the SBA 7(a) Loans
- SBA 7(a) Loan Calculator
- Small Business Loan Calculator